Under appreciated risks

We talk about risks not to dramatize all of the things that can go wrong, but rather to highlight some the things that often go unnoticed and can fairly easily be avoided. Identifying and managing these risks will help level the playing field for you by avoiding unnecessary costs and anxiety and by improving the productivity of the resources you dedicate to investing.

Keep your eye on the prize

With so many issues and so many providers, it's easy to get distracted from what matters most. Since the purpose of investing is to provide for some future benefit, usually in the form of future spending capability, it is extremely important to be clear about exactly what that future benefit is. By establishing these goals upfront, either informally or more formally in an investment policy, you will be in a much better position to evaluate which investment options are most appropriate and which ones are not.

Markets change, what do you do?

Many investors start with the assumption that investing in stocks or bonds is a known quantity and a familiar proposition. Instead, the character and attractiveness of markets change over time. Throughout history, both exceptionally strong and exceptionally weak returns have been clustered around certain periods of time. The consequences of ignoring or misreading the investment landscape can severely impair your chances of investment success. For more information about what can reasonably be expected from stock market returns, see: Return expectations: Fact vs. fiction.

Creditism

Asset prices and economic growth are influenced by the amount of money and credit available. An under-reported fact is that since the mid 1960s, total credit has grown in the US at a much faster pace than GDP. Since GDP can be thought of as national income, this means that debts have grown much faster than the country’s ability to repay them. This situation becomes even more extreme when liabilities for health care and retirement are included. The bottom line is that one of two things must happen: Either credit starts growing more slowly than GDP in which case the growth in both asset prices and the economy will be stunted relative to recent history, or credit continues growing beyond sustainable levels and eventually the value of the US dollar becomes threatened. Both of these situations have serious consequences for investors.

Principles vs. agents

One of the important changes in the investment landscape over the last few decades is that a much larger proportion of assets are now managed by third party "agents" rather than by people who actually own the assets themselves, i.e., "principles". Some of the potential consequences of this trend include increased conflicts of interest which can lead to shorter investment horizons, greater trading frequency, and higher risk taking.

Passive proliferation

While passive funds can certainly provide cheap access to markets, their value proposition is dependent on the presence of a significant cohort of active investors competing to establish reasonably efficient pricing. As passive funds have proliferated, the size and power of the active cohort has diminished commensurately. Two important effects have emerged from this trend. One is that the basis for efficient pricing has become weaker which is creating incremental opportunities for active managers. The other is that the ability of equity investors to diversify risk is being eroded which makes all equity investing riskier than it used to be.

Lies, damn lies, and statistics

Statistical models can be extremely helpful in framing complex situations but they can also create a false sense of security when presented without appropriate caveats. Far too often we find normal probability distributions are used to model returns and asset allocations without any mention of the fact that these models perform worst at market extremes when the consequences are greatest. The consequences of such applications almost always make investments (and revenue opportunities for presenters) look much more appealing than they really are.

The single most important risk we find lurking in models based on normal distributions is that the "fat tails" that result from extreme events are under-represented. While normal distributions do a reasonable job of modeling returns in "normal" times, such distributions can be wildly off the mark when times are not normal. The fact that extreme events almost always occur within the horizons of long term investors, and the fact that such events have been occurring more frequently in recent years, sounds the alarm that extra care should be taken to fully incorporate the effect of fat tails in decision making. Normally this means taking on less risk or implementing some form of insurance.

Another common oversight we find is that most statistical models tend to focus on arithmetic mean returns rather than geometric mean returns. Analyzing the distinction involves some math but the implication is simple: a good chunk of the statistical return analyses typically found in asset allocation models both understate potential risks and overstate likely returns. Such analyses can quite obviously lead to erroneous conclusions.

Fundamental fiction?

In the current context of high levels of government debt, progressively more information is becoming politicized which tends to diminish its quality and reliability. Since good analysis of economic fundamentals is an important tenet of successful long-term investing, the uncertainty of key inputs ought to be incorporated into one’s analysis. Often this is accomplished by demanding higher returns for a given level of cash flows.